What would happen if you wanted to cook dinner and had only one ingredient to work with? Clearly that’s not the ideal way to go about preparing a meal and chances are that you wouldn’t have much of meal to show for.
Now consider the same with your investment portfolio; what if all your money is invested in only one product or asset class. This can not only restrict returns but also exposes you to higher risk due to lack of diversification.
This is where the importance of asset allocation comes to the fore. Asset allocation has been the buzzword in the investment and personal finance industry since long. However, still very few understand the concept, its practical application and even its importance for matter.
What is asset allocation?
Simply put, asset allocation is the process of choosing the right mix of asset classes while constructing the portfolio which in turn, can help in reducing the overall risk and enhancing returns.
The principle of asset allocation draws from the time-tested adage: do not place all your eggs in one basket. The intent is to enjoy the benefits of diversification. Diversification helps minimise risk because losses in one type of investment can be offset by gains in others.
Essentially, asset allocation is based on the premise that different asset classes perform differently in the given market conditions. For instance, stocks provide faster growth and income, but at higher risk, bonds provide stability and lower risk. The importance of diversification also stems from the inability to predict the performance of any asset class for a given time period.
Thus, through asset allocation an investor can diversify his portfolio thereby hedging its performance against risk. This is achieved by investing across asset classes with different levels of risk which helps the investor balance out the overall portfolio risk and optimize the returns. For example, if an investor has invested Rs 100 in equity and debt in the ratio of 3:2. Assuming that the equity markets decline by 50%, the equity component will theoretically fall by 50% to Rs 30 but the debt component (assuming that it gives a fixed interest of 7%) would be valued at Rs 43. So, the final investment value is Rs 73.
Now, had the investor invested the entire amount in equity, the investment value would have dropped down significantly to Rs 50. Now consider a real life example, during the fall in markets in 2008, many investors who were predominantly invested in equities saw their portfolios decline by more than 50%.
During the same time there was an asset class which fared significantly better i.e. gold. When the equity markets declined by nearly 52%, it was gold as an asset class which actually delivered positive returns of 25%*. Investors who had included gold in their portfolios would have navigated through the downturn far better, thanks to the cushion provided by rising gold prices.
How it works
As with any rewarding venture, the asset allocation process requires some time and effort on the investor’s part, given that there is a vast gamut of investment avenues and product offerings to choose from. Before choosing the relevant offerings and building an optimal portfolio, an investor should ask the following questions:
- What is the investment goal i.e. what does one intend to achieve with the investment?
- What is the investment horizon i.e. for how much time can one stay invested?
- What is the risk tolerance level i.e. how much risk can one take?
A well-designed portfolio that plies the principles of asset allocation can help investors achieve their investment goals. For example, an investor who is about to retire and will have no source of income post his retirement would do well to opt for a conservative asset allocation and construct a portfolio that emphasizes more on regular income with lower risk i.e. invest more in fixed income avenues (like bonds, assured return schemes and cash) rather than equity.
On the other hand, consider an investor, who is young, can take on high risk; such an investor can adopt an aggressive asset allocation with higher exposure towards equity and related products. Once an answer to the aforesaid questions is available and the asset allocation mix is decided upon, the investor can go about identifying the best suited investment products in a more informed manner. .
Asset allocation does not simply imply creating a right mix of equity, debt and cash. It is comprehensive mechanism wherein an investor can diversify across different investment avenues while creating the ideal portfolio. Some of the popular investment products available in the market today are listed below:
- Mutual funds
- Fixed income instruments
- Fixed deposits
- Pension funds
- Real estate
- Unit linked insurance plans
- Global funds
While an informed investor can create a well designed portfolio for himself, there are products in the mutual funds and insurance segments which offer a new or passive investor the benefit of an inbuilt asset allocation model.
As a result, the investor need not go about determining the asset allocation and selecting various investment avenues. These asset allocation products are targeted at investors who neither have the time nor the required technical know-how to decide on the ideal asset allocation mix..
Also investors must consider taking assistance from a professional financial advisor who can help them with both, determining the right asset allocation and also build a suitable portfolio. Now having discussed the what’s and how’s of asset allocation, there are a few points which must be remembered before investing.
Points to remember
Rebalancing: While the importance of asset allocation and constructing a diversified portfolio cannot be overstated, investors must not treat it like a one-time activity. In other words, they should not adopt the "fill it, shut it and forget it" approach. A timely review and rebalancing of the asset allocation mix is required to ensure that the investor stays on course to achieve the ultimate goal.
Taxation: An investor must be aware of the tax implications while building the portfolio. For instance before selling an investment, the investor should consider the short-term or long-term capital gain tax liability which may impact the overall returns on the portfolio.
Understanding the portfolio: Notwithstanding the presence of an investment advisor, it is important for the investor to know the specific investment avenues that form a part of his portfolio. An investor should make an effort to understand the portfolio holdings. Each component (investment avenue) is required to play a specific role in the portfolio. Hence, it is vital that investors be unambiguously aware of investments and find out if they are playing their part. This in turn can help investors initiate corrective action, if and when required.
Greed and fear: An investor must avoid the greed and fear factor i.e. they should not sell or buy an investment in haste or panic. This may lead to them deviating from the investment objective and even result in erosion of capital. Short-term fluctuations should not matter to a long-term investor. Instead, the key should be to focus on the long-haul, while consistently adopting a disciplined investment approach.
In conclusion, asset allocation has an important role to play in helping investors achieve their investment goals. Hence, the need to pay due attention to it while constructing the portfolio.
(*Return of NCDEX spot gold taken here for reference)